Oct 15, 2001 - Living on borrowed time
US debt bubble set to burst:
Originally posted @ BreakViews.com  By Edward Chancellor

During hard times, one would expect consumers and corporations to batten down the hatches. One consequence should be a reduction in private sector debt. In the US, however, the opposite is happening.  Despite the implosion of the stock market bubble, its less famous twin – the credit bubble - continues to inflate. To date, the succession of rate cuts by the Federal Reserve has simply encouraged the build-up of debt. This process is unsustainable.

The prosperity of the US economy in the late 1990s was enabled by credit creation vastly exceeding the growth of GDP. During the second half of the decade, every $1 increase in GDP was accompanied by more than $3 of new debt. Corporations used their debt to finance their capital investments and to retire equity. In the short term, this had a leveraged effect on earnings per share, which did wonders to share prices and executive stock options packages. Now, US companies face a debt hangover: the corporate sector is running a financial deficit greater than 7% of GDP. This is currently being financed by further debt, with nearly $1 trillion worth of corporate bonds issued in the year to date.

A corporate financial deficit of this size would be sustainable if US households saved more. But they are in equally dire straits. The average credit card balance has climbed to over $7,500, and personal bankruptcies are running at an annualized figure of 1.5m. In the first half of this year, consumers increased their debt by around $300bn, most of which came from the refinancing of mortgages following the cuts in interest rates.

It is doubtful whether this situation can continue much longer. Bad debts are rising. Credit card delinquencies have climbed to 6.5% from little over 5% a year ago.  The same problems afflict the corporate sector where defaults on junk bonds exceed the levels of the early 1990s. There is a danger that the risk premium on debt will rise faster than the Federal Reserve can cut interest rates.



 

In Context

Since 1996, outstanding credit doubled in US while GDP grew 20-30%. US financial liabilities rose $12 trillion to $22 trillion, 1995-2000.

The US corporate financial deficit was $271bn in H1 2001. US corporate sector has funding gap of $710bn at annual rates, up from less than $200bn in 1991. Much of this has been financed by foreigners who now own more than $7 trillion of US financial assets.

In late 1990s, US debt to equity ratio rose from 84 to 116%. The deterioration of balance sheets, however, has been concealed by rising stock prices: the debt to market capitalisation ratio fell from 0.6 in 1995 to 0.4 in Q1 2001.

US household credit has risen from $4 trillion to nearly $8 trillion (between 1995 to Q1 2001). In the first half of 2001 US consumers increased debt by $300bn, of which $239bn came from housing market, 30% higher than previous record.  Credit card delinquencies rose to 6.47% in July 2001, from 5.16% a year earlier.